Don't Forget The Working Capital
Nov 20, 2008
Don't Forget the Working Capital
In the course of an acquisition, it's common for buyers and sellers to focus on critical deal terms such as the purchase price, earn out options, intellectual property transfers, deal structure, non-compete agreements and employment agreements. While not as obvious as the above noted issues, deal terms related to the working capital position can be critical to the successful transition of a business.
From a buyer's perspective, the valuation of a company is usually based on cash flow, which is the by-product of a company's customer base, intellectual property, brand, physical assets and various other intangible assets. This value ultimately becomes the negotiated purchase price for the acquisition. However, it does not take into account the value or obligation of the net working capital position. Before we can talk about valuing working capital in an acquisition, buyers often ask the following question:
Q: Do I need to buy the working capital position from this company?
A: With very few exceptions, the answer is yes. When the seller retains the working capital position, the buyer loses control over the customer base and the vendors. After the acquisition is complete, the seller's motives may not be in line with that of the buyer. For example, the seller may become aggressive with some slow paying customers and damage the goodwill of the business. In addition, the seller may delay or not make payments to critical vendors that could disrupt the buyer's supply chain.
Once it is determined that the buyer should control the working capital, the issue of value comes up.
Q: Is it already included in the purchase price or is it an additional consideration component?
A: While either way is acceptable, I prefer to value the working capital position as an additional consideration as it gives the seller the incentive to keep the business running as it has always been running. If a buyer and seller agree that the working capital position is included in the purchase price, care must be taken to establish an expected range for the working capital position as well as the method of securing a working capital position that is outside of the expected range. Regardless of the method chosen, an agreed upon method of valuation and measurement period should be defined up front.
Valuation measures are critical for items such as accounts receivable and inventory. In the case of accounts receivable, the total receivable balance is usually not collectable at any point in time. One method of determining value is to pay a percentage of the dollar based on the aging of the various receivable buckets (current, over 30, 60, 90 days old). Another method is to simply pay for funds received that were for services performed prior to the acquisition date. This method requires some tracking diligence particularly when the selling company has loose receivable tracking procedures.
I like to defer the measurement of working capital for at least 90 days after the acquisition date. This gives the buyer time to determine whether the current assets have been realized; it also gives the buyer time to determine the accuracy of the current liabilities. This also gives the sellers time and incentive to assist the buyer in collecting receivables, negotiating trade payables and resolving any other claims of the business.
If you are considering buying or selling a business, contact your B2B CFO partner to assist you in all the particulars of business transactions. We are experts who can help you plan and manage your corporate transition. Planning ahead will ensure you get the value you deserve.